International

Economics & Finance

Chapter 11: Foreign Exchange
Required Reading: Carbaugh, Chap 11
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Learning Objectives
Introduction of Foreign Exchange Market
Different Types of Forex Transactions and
Markets
Understand Demand and Supply of
Currency
Short-run and Long-run Determinants of
Exchange Rates


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Foreign Exchange Market
Largest and Most Liquid Market in the World
Average Daily Turnover in 2010: $3.98 trillion
No Organized Structure, No Centralized
Meeting Place
Transaction can Occur Anywhere as long as it is
within the international telecommunication
system
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Foreign Exchange Market:
OPEN 24 hours






Dominated by 4 major currencies
USD, EUR, JPY, GBP
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Market Turnover by Location, by
Currency, and by Instrument
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Report from BIS (Bank for International Settlements)
http://www.bis.org/publ/rpfx13fx.pdf


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Foreign-Exchange Market
3 Levels of Transactions
1. Commercial Banks and Commercial Customers
E.g.) SG Exporter & DBS
2. Domestic Interbank through Broker
E.g.) DBS vs OCBC
3. Active Trading in Foreign Exchange with Banks
Overseas
E.g.) DBS vs Barclays

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Foreign Exchange 101:
Basic Terminology
Foreign Exchange Rate = Price of Currency
Bid Rate - Price which Bank is willing to Pay
Offer Rate - Price which Bank is willing to Sell
Spread - difference between the bid and the
offer rate
Banks Bid Quote < its Offer Quote

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Foreign Exchange 101:
Basic Terminology
Exchange rate
Example: S$ to one unit of foreign currency
Sell (Ask) Buy (Bid)
US dollar 1.258 1.21
If you bring SGD100 and Change to USD:
SGD 100 / 1.258 = USD 79.49
If someone else brings USD79.49 to change to SGD:
USD 79.49*1.21 = SGD 96.18
Money Changer will keep SGD 100 - 96.18 = SGD3.82

Exchange rate reported - The Midrange between bid and offer


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Foreign Exchange 101:
Basic Terminology
On the spread
Bid Offer Vol
$0.5851 per Franc $0.5854 per Franc 1 Million

Profit = 0.0003 (spread) x 1 M = $300

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Foreign Exchange 101:
Basic Terminology
Depreciation
It takes more units of a nations currency to purchase a
unit of some foreign currency
Appreciation
It takes fewer units of a nations currency to purchase
a unit of some foreign currency
Cross exchange rate
Exchange rate between any two currencies (such as
the Euro and AUD)
Derived from the rates of these two currencies in
terms of a third currency (USD)
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In S$ (S$ to one unit of given
foreign currency)
Per S$ (No. of foreign currency to
buy one unit of S$)
Wed Tues Wed Tues
US dollar 1.234 1.22 0.810 0.812
How did the S$ move against the US$ from Tues to Wed?
Ans: _________________appreciated
_________________ depreciated

Cross Exchange Rate between 2 non-dollar currencies
In US$ (US$ to one unit of given foreign currency)
Euro 1.41
Australian dollar 1.053
US dollar -
Find the cross exchange rate between Euro and Australian dollar.
Ans: Each Euro can buy about 1.34 Australian dollars
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Types of FX Transactions
Spot Transaction
Transaction on the Spot; for those who need to change currency
Now
Forward Transactions / Future Contract / Options
Transaction for the future date; for those who wants to hedge the
risk (or take more risk) of exchange rate movement
Currency Swap (FX Swap / Cross-Currency basis Swap)
Conversion of one currency to another at one point of time, with
Agreement to reconvert it back at specified time

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Spot Transactions
Outright Purchase or Sale of Currency On the
Spot
Cash Settlement < 2 business days after Trade
Date
Greatest Risk of Exchange Rate Fluctuations
Takes place in Spot Market
Highest Volume in Foreign-Exchange
Transactions


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Forward / Future Transactions
Used Mainly by Importers & Exporters to reduce
Risks of Exchange Rate Movement (Hedging)
However, No Risk means No Gain even if Exchange
Rate move in your Favour
Purchase / Sale of Foreign Currency on a Specific
Future Date
Forward Rate = Quoted as a Premium or Discount
from Spot Rate
Forward Market = Over the Counter by Telephone,
Delivery Date & Size can be Customized
Futures Market = Date & Size are Standardized, Listed
in Large Exchange Market such as Chicago, Tokyo, and
Singapore


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Currency Swap Transactions
Conversion of One Currency to Another with Agreement to
Re-convert it to Original Currency at Specified Time in Future
Rates of Both Exchanges are Agreed to in Advance
Provide an efficient means by which Banks and Corporations
can Meet FX Needs Over a Period of Time
Example: Company Taking Loan in Foreign Currency
A Singapore Company take USD 1million loan over 3 years
Company generates income in SGD, but need to make
repayments for Loan in USD every quarter
Swap arrangement to convert USD SGD on the date which
they took loan, and convert SGD USD on the days which
company make repayment over next 3 years



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Exchange-Rate Determination
Exchange Rate = Price of Currency
Demand & Supply of Currency
Demand for GBP in USA = Correspond to Debit
Items of Balance-of-Payment for USA
Supply of GBP in USA = Correspond to Credit Items
of Balance-of-Payment for USA
Supply & Demand will indicate Equilibrium
Exchange Rate


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Demand & Supply of GBP in US

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Pound
Appreciation
Pound
Depreciation
Price of Pound in terms
of Dollars
(GBP 1 = USD ??)
Factors Affect Demand
Demand for GBP in US
More Americans want to import British goods, they
need more GBP to make payments Demand Curve
will shift Rightward
Less Americans want to invest in UK Need Less GBP
for Buying UK stocks, bonds, etc Demand Curve will
shift Leftward




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Less American wants to invest in UK, they will demand less GBP
As a Result, Demand of GBP will shift leftward
GBP will Depreciate (USD will Appreciate)
Factors Affect Supply
Supply of GBP in US
More British want to import US goods (US Export
Increase), they supply more GBP to change into USD
Supply Curve will shift Rightward
Less British want to invest in US Supply Less GBP
Supply Curve will shift Leftward




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More British wants to import goods from US (US export increase),
Supply of GBP increases.
As a Result, GBP will Depreciate (USD will Appreciate).
Appreciation
Advantages
Import becomes Cheaper
Lower Import Price = Low Inflation
Benefit when We Travel Abroad

Disadvantages
Exporting Industries Suffer (Export Price Increase)
Import-Competing Industries Suffer
Foreign Tourists find us Expensive

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Depreciation
Advantages
Exporting Industries Benefit
Foreign Tourist find our Countrys Goods Cheap

Disadvantages
Import becomes More Expensive (consumers suffer)
Inflationary Pressure from Expensive Import
Disadvantage for us to Travel Abroad



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Managing Foreign Exchange risk
Manage foreign exchange risk using forward contract
Hedging
Process of avoiding or covering a foreign-exchange risk
Used by Importers & Exporters
Also Used to Secure the Returns from Investments
Overseas
Some firms do not hedge
Currency fluctuations even out over the long term
Spread the Location of Production


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Example: Hedging
SG importer orders furniture from Italian manufacturer. They
need to make a Payment of 50,000 due in 3 months time
SG importer can choose the following:
Do nothing, take on exchange rate risk (uncovered position), or
Enter into spot transaction now (covered position), or
Enter into a 3 month forward/ futures contract (Hedging)
Which one has More/Less Risk?



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Hedging
Jan spot rate is S$1.603: 1
Apr spot rate is S$1.700: 1

Option 1: Do nothing
If spot rate were S$1.7 to 1 in Apr, SG importer would have
to pay 50K x 1.700 = S$85,000

Option 2: Buy now in Jan & Prepare for Apr
payment
Amount paid in Jan = 1.603 x 50K = S$80,150
Must Incur Opportunity Cost of SGD exchanged into


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Hedging
Assume:
Jan spot rate is S$1.603: 1
In Jan, 3 mth forward rate for Apr Settlement is S$1.65: 1

Option 3: In Jan, Enter into 3 mth forward contract
Amount due in Apr= 1.65 x 50K = S$82,500

Amount Saved Compared to No Hedging: 85,000 - 82,500
= 2,500
SG importer hedged against depreciation
However, must give up the gain if exchange rate
appreciates

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Interest Arbitrage
Process of Moving Funds into Foreign Currencies to take
advantage of Higher Yields Abroad
Uncovered Arbitrage (Carry Trade)
Example: Singaporean investor exchange SGDEUR at spot rate,
invest in Spanish Govt Bond, and when the Bond matures,
exchange EURSGD at spot rate
Spanish Govt Bond offers much higher yields than SG Govt Bond,
Taking Advantage of Interest Rate Difference + Taking Risk of FX
Rate Change (If EUR were to appreciate in future, Return
becomes even Higher)
Covered Arbitrage
Example: Singaporean investor exchange SGDEUR at spot rate,
invest in Spanish Govt Bond, and Enter into Forward Contract to
secure the amount of Return in SGD
Remove the Risk of FX Rate Change

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Determination of Forward Rate
Interest Rate Parity
Theory that Return of Investment will be the Same
because the Difference in Interest Rates are offset by
the Change in Exchange Rate
Forward Rate = Set in order to Offset Gain from
Difference in Interest Rate between 2 Countries
However, Parity Does Not Always Hold Often Rates
can Fluctuate Due to Change in Monetary Policy,
Economic Condition, and How Traders (Market) View
the Country
Important Concept for Next Weeks Topic



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